When is an ETF not an ETF?

Growth in the European ETF industry is being held back by too much private trade over the counter

If asked whether exchange traded funds are traded on exchange, you’d probably say something like “Yes, obviously. It’s in the name.” Well here’s a crazy thing: it turns out the majority of ETF trading in Europe is actually done off exchange.

It is estimated around two thirds of the market is done in private ‘over the counter,’ where typically an institution phones up a market maker to get a good price for buying a huge amount of ETF shares. This might not sound relevant for most of us smaller retail folk. And the techy speak can be a bit off-putting.

But actually, it does affect us, because it means we might not be getting the best price out there. It’s also holding back the growth of the European ETF industry.

Under the surface a lot of trades are being done that we are unaware of

For the one third of the market which is traded on exchange, these trades are ‘reported’. This means investors can see how much an ETF is being traded and the prices investors are getting for buying or selling.

Generally, the more an ETF is traded, the tighter the pricing tends to be, meaning it should be lower cost. And if an investor sees a good price, the more likely they are to trade on exchange.

But when buying or selling an ETF is done in private over the counter, it’s not obvious to any of us how much is being traded and what prices investors are getting.

So this means when you look on a stock exchange to get this information, what you’re seeing is only the tip of the iceberg. Under the surface, there’s a whole load of trades being done that we don’t know about.

The problem with this is big investors who look on exchange and don’t think an ETF is being traded that much will be more likely to join in with transacting over the counter, to get a better deal.

If you’re still thinking “well, this doesn’t sound like a problem for me, I’m only a small investor,” think again. The more investors trade, the lower the cost of buying shares in an ETF can be.

This is because the bid-offer spread is generally tighter. This spread is the difference in the price of buying and selling these shares.

Much like buying and selling currency when going on holiday, you tend to end up paying a bit more to buy the shares and get slightly less when selling. For example, if the offer price I can buy at is 101p at best, and the bid price I can sell at is 99p, then the spread is 2p. So once you’ve bought it at 101p, you need to see the price you can sell at go up by 2p.

Those ETFs which are traded more have lower bid-offer spreads as it is efficient to find a buyer and a seller, making the transaction cost to make the match smaller. Conversely, a more niche, less traded ETF will likely have a much bigger spread.

But there’s another element to consider, that can make the spread bigger. This is based on the actual asset the ETF is tracking. If you buy an ETF tracking the FTSE 100, for example, the underlying shares are heavily traded and very liquid, meaning the fund tracking these shares is likely to have a tighter spread.

However if you go for a frontier market ETF, these shares are harder to trade, as there are all sorts of issues to consider, from corporate governance problems to political risks. This means there’s likely to be a wider spread when buying and selling the ETF.

So getting a tight spread is important in lowering your overall costs. And if big institutional investors can play a part in this by trading on exchange, then the market should be encouraged to move in this direction.

There has been talk of developments in European regulation which could require over the counter trades to be reported, which would give everyone a better idea of what is going on. However, whether this comes into action and has such an impact remains to be seen.

At the same time, the more retail use ETFs the greater the volume of trading done on exchange, as in the older US market. And with more UK investors across the board adopting ETFs, this trading issue should improve.

Still, it just goes to show, despite the name of any investment, it’s worth digging under the surface to understand what’s really going on.